Chapter 19: Accounts Receivable and Inventory

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Chapter 19
May 4, 2009
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Learning Objectives

• How and why firms manage accounts receivable and
  inventory.
• Computation of optimum levels of accounts
  receivable and inventory.
• Alternative inventory management approaches.
• How firms make and evaluate credit policy
  decisions

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Why do firms accumulate accounts receivable and
inventory?

• Given that accounts receivable and inventory are
  assets that do not provide an explicit rate of
  return, it is important to understand why firms
  might still want to have these investments.
• Granting credit, resulting in Accounts
  Receivable, is often an essential business
  practice and can enhance sales. (But also will
  increase costs.)
• Holding adequate inventory is necessary to avoid
  loss of sales due to stock-outs and have an
  efficient manufacturing process.

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Finding the Optimum Level of Accounts Receivable

• Accounts Receivable represent your money sitting
  in someone elses bank account. It earns you
  nothing!
• So, if the firm does grant credit, how do we
  minimize the impact on cash flow
• Firms managers must review the firms credit
  policies and evaluate the impact of any proposed
  changes in policies based on the NPV of
  incremental cash flows due to the proposed
  changes

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Accounts Receivable - Terms

• The terms of sale are generally stated in the
  form X / Y, n Z
• This means that the customer can deduct X
  percentage if the account is paid within Y days
  otherwise, the full amount must be paid within Z
  days.
• Example 2/10 n 30
• The company offers a 2 discount if the invoice
  is paid in 10 days. Otherwise,
• Balance due in 30 days.

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Average Collection Period (ACP)

• Old Policy 2/10, n30
• 35 of customers pay in 10 days
• 62 of customers pay in 30 days
• 3 of customers pay in 100 days
• ACP(.35x10)(.62x30)(.03x100)25.1 days
• New Policy 2/10, n40
• 35of customers pay in 10 days
• 60 of customers pay in 40 days
• 5 of customers pay in 100 days
• ACP(.35x10)(.60x40)(.05x100)32.5 days
• (If sales are 1M per day, this will cost 7.4M!)

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Analysis of Accts. Receivable Changes to Credit
Policy

• Develop pro forma financial statements for each
  policy under consideration.
• Use the pro formas to estimate incremental cash
  flows by comparing forecasts to current policy
  cash flows.
• Use the incremental cash flows to estimate the
  NPV of each policy change.
• Choose the policy change that maximizes the value
  of the firm (highest NPV).

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Analysis of Accts. Receivable Changes

• ExampleABC Corporation is considering a credit
  policy change from offering no credit to offering
  30 days credit with no discount
• Why might they do this?
• -Increase sales
• -Increase market share
• What costs will the firm incur as a result?
• -Cost of carrying accounts receivable
• -Potential increase in bad debts
• -Credit analysis and collection costs

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Analysis of Accts. Receivable Changes

• Assume the Net Incremental Cash Flows associated
  with ABCs new credit policy are as follows
  (They lose one month of cash flow which they will
  have to borrow)
• External financing (Init. Investment)
  28,000 t0
• Increase in sales 30,000
• Increase in COGS 15,000
• Increase in Bad Debts 3,000
• increase in Other Expenses 5,000
• Increase in Interest Expense 500
• Increase in Taxes 2,600
• Total Incr. Operating Cash Flow 3,900/yr.

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Analysis of Accts. Receivable Changes

• Calculate the NPV of the change (k 12)
• PV of the expected inflows of 3,900 per year
  from t 0 to infinity (perpetuity) 3,900/.12
  32,500
• NPV PV of inflows - initial investment
  32,500 - 28,000 4,500
• Since NPV gt 0, ABC should undertake the credit
  policy change
• Note If they keep the 28,000, cash flow at 12
  3,360

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Methods of Collection
Most firms use some of the following

• Send reminder letters.
• Make telephone calls.
• Send in big Gene
• Hire collection agencies.
• Sue the customer.
• Settle for a reduced amount.
• Write off the bill as a loss.
• Sell accounts receivable to factors.

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Inventory Management

• Typically, inventory accounts for about four to
  five percent of a firm's assets. In
  manufacturing firms, this could be 20 to 25 of
  the firms assets.
• Inventory sitting on your shelf earns nothing!
• In fact, it costs you 20 to 30 of the value of
  the inventory just to keep and maintain it.
• Therefore, the objective is to minimize the
  investment in inventory without sacrificing
  production requirements

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Inventory Mangement

• In order to effectively manage the investment in
  inventory, two problems must be dealt with how
  much to order and how often to order.
• The economic order quantity (EOQ) model attempts
  to determine the order size that will minimize
  total inventory costs.

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Inventory Management

• Determining Optimal Inventory (where total costs
  are minimized)

Note We are not talking about the cost of the
Inventory itself, but costs of holding
and maintaining the inventory
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Inventory Costs

• Carrying Costs
• Warehouse rent, insurance, security costs,
• utility costs, maintenance costs, property
  taxes,
• move and re-arrange, obsolescence, and
  opportunity cost, i.e., using cash for profitable
  projects rather than being tied up in inventory.
• Ordering costs
• Clerical expense, telephone, Material Resource
  Planning (MRP) system, management time, receiving
  costs, etc.

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The EOQ Model assumes the firm orders a fixed
amount (Q) at equal intervals.
Inventory Level (units)
Order Quantity Q
Time
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The EOQ Model
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Where OQ Order Size (order quantity) S
Annual Sales Volume CC Carrying Cost per
Unit OC Ordering Cost per Order
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Cost ()
Ordering Costs, per unit
Ordering costs per unit go down as order size
increases. Assumes ordering costs are
relatively fixed.
Order Size (units)
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Carrying Costs
Carrying costs increase as the size of the
inventory increases.
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Total Costs Carrying Costs Order Costs Total
Cost OQ x CC S x OC 2 OQ
Cost ()
Y
The economic order quantity is the intersection
of the X and Y points where total inventory cost
is minimized
X
Order Size (units)
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Inventory Management

• Determining Optimal Inventory

• The ordering quantity that minimizes the total
  costs of inventory.

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Inventory Management

• Determining Optimal Inventory

• Economic Order Quantity (EOQ)

Example Awesome Autos expects to sell 1,560 new
automobiles in the next year. It currently costs
40 per order placed with the manufacturer.
Carrying costs amount to 50 per auto. How many
autos should they order each time they place an
order?
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Inventory Management

• Determining Optimal Inventory
• Economic Order Quantity (EOQ)

Example Awesome Autos expects to sell 1,560 new
automobiles in the next year. It currently costs
40 per order placed with the manufacturer.
Carrying costs amount to 50 per auto. How many
autos should they order each time they place an
order? How many orders per year?
OQ 50?autos in each order
Place 1,560/ 50 31.2 orders each year Order
cost 31.2 x 40 1,248
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Inventory Reorder Point

• If total demand is 1560 and 52 weeks in year,
  then 1,560 / 52 or 30 cars sold per week.
• If it takes one week to get a shipment of cars
  from the manufacturer, then 1 x 30 or when you
  get down to 30 cars, they would reorder

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Safety Stock

• Assume Awesome autos does not want to risk
  running out of cars and lose sales
• They determine that to offset variations in the
  delivery cycle, they need a safety stock of 20
  autos
• The amount of safety stock is added to the
  inventory reorder point
• So the new inventory reorder point would be 30
  plus 20 or 50 autos

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Inventory Management with Safety Stock- Order
before inventory is at zero.
Inventory Order Point
70
EOQ
50
Depleted Stock During Delivery
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Safety Stock
Actual Delivery Time